Appropriate market response needed

A new working paper from the IMF details some of the financial policies necessary to mitigate climate change and outlines some of the implications that profound disruption to the climate system may cause.

“Mitigating climate change requires a large-scale transition to a low-carbon economy. The scientific consensus is that climate change is undermining the ecological systems on which human and all other forms of life depend, and that mitigating climate change is crucial to preserving the conditions for economic growth and life within earth systems,” the IMF states in its report

“There is also a strong scientific consensus that limiting global warming to well below 2°C requires a transformation in the structure of global economic activity on a massive scale. On their own, markets cannot deliver sufficient mitigation. Market failures, unaddressed and exacerbated by government failures, prevent an appropriate market response to the challenge of mitigating climate change.”

Broad menu of policy options

According to the IMF market failures can prevent needed long-term private investment even if public investments were sufficient and relative energy prices appropriate, justifying the use of financial policies as complements to fiscal policies.

A wide range of macroeconomic and financial policy tools can affect climate change and can be part of the package of measures for mitigation. While both international policy coordination and domestic policy action are key to addressing climate change, this paper focuses on the latter.

A broad menu of policy options is outlined by the IMF from which policymakers can choose. Fiscal policy options revolve around carbon pricing (explicit and implicit), spending and investment, and public guarantees. The needed transformation in the productive structure of the economy requires a change in the underlying financial asset structure, implying a key role for financial policy tools.

Policies can be divided into those that aim to correct the lack of accounting for climate risks for financial institutions and those that aim to internalize externalities and co-benefits at the level of society. The former support mitigation by changing the demand for green and carbon-intensive investments, as well as relative prices.

The latter work through similar channels but give rise to questions about appropriate policy tool assignment, trade-offs and political economy. Monetary policy tools may have a role to play. Some options are within most central bank mandates (reflecting climate risks in largescale asset purchase programs or collateral frameworks), while others are more controversial (green QE, credit allocation policies, adapting monetary policy frameworks).

More research is needed on the most effective policy mix for climate change mitigation, and the role of climate mitigation in the overall policy framework. While some macroeconomic and financial tools are clearly desirable and complementary, others may substitute for each other, giving rise to trade-offs.

The impact of macroeconomic and financial policies on climate change implies that macroeconomic policy frameworks can be designed with the explicit additional goal of achieving sufficient mitigation within the time frame imposed by the threat of climate change. This raises questions about the role of mitigation in the overall policy framework and interactions with other goals. Coordination among policy areas could be critical for mitigation, and this issue requires more research.

Read this working paper in full:

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